Question

Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply:

1. The machinery falls into the MACRS 3-year class

2. Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.

3. The firm’s tax rate is 40%

4. The loan would have an interest rate of 15%. It would be nonamortizing, with only interest paid at the end of each year for four years and the principle repaid in year 4.

5. The lease terms call for $400,000 payments at the end of each of the next 4 years.

6. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $250,000 at the end of the 4^th year.

You are required to:

1. Prepare the Depreciation Schedule.

2. Find the after-tax cash flow and PV of the lease alternative.

3. Find the after-tax cash flow and PV of the borrow & buy alternative.

4. Explain which alternative you would recommend giving your reasons.

Answer 1

		0	1	2	3	4
1)	Depreciation % [MACRS 3 Year]		33.33	44.45	14.81	7.41
	Depreciation		$    4,99,950.00	$      6,66,750.00	$       2,22,150.00	$      1,11,150.00	$    15,00,000.00
2)	PV of lease alternative = -400000*(1-40%)*(1.09^4-1)/(0.09*1.09^4) =	$      -7,77,532.77
	[Discount rate = 15%*(1-40%) = 9%]
3)	Balance of loan		$ 15,00,000.00	$    15,00,000.00	$     15,00,000.00	$    15,00,000.00
	Interest at 15%		$    2,25,000.00	$      2,25,000.00	$       2,25,000.00	$      2,25,000.00
	Cash flows of buying:
	Principal repayment					$ -15,00,000.00	$ -15,00,000.00
	After tax interest [Interest * (1-40%)]		$   -1,35,000.00	$     -1,35,000.00	$     -1,35,000.00	$     -1,35,000.00
	After tax salvage value = 250000*(1-40%) =					$      1,50,000.00
	Tax shield on depreciation		$    1,99,980.00	$      2,66,700.00	$           88,860.00	$          44,460.00
	`		$        64,980.00	$      1,31,700.00	$         -46,140.00	$ -14,40,540.00
	PVIF at 9% [PVIF = 1/1.09^n]		0.91743	0.91743	0.91743	0.91743
	PV at 9%		$        59,614.68	$      1,20,825.69	$         -42,330.28	$ -13,21,596.33	$ -11,83,486.24
	PV of buying	$    -11,83,486.24
4)	As the present value cost of leasing is lower, the firm should lease the machine.